MORGAN STANLEY: 'The Government Of The United States Is Not Going To Default'

REUTERS/Jonathan ErnstThe U.S. House of Representatives remains fully lit during a rare late-night Saturday session at the U.S. Capitol in Washington, September 28, 2013.

There's not much good to be said about the ongoing U.S. government shutdown, which was triggered by Congress' inability to come to a budget deal.

However, most experts are now saying that the shutdown and budget debacle is just a sideshow to the real risk: the debt ceiling.

"The budget debate and the looming debt ceiling are two distinct issues: the former is related to appropriations authority and the later pertains to debt issuance authority," wrote Morgan Stanley's Vincent Reinhart.

There's a fear out there that the U.S. may have to default on its obligations if the debt ceiling isn't raised.

But Reinhart is confident that a default won't happen. From his note (emphasis added):

...There has been a good deal of public and media confusion surrounding the approaching funding deadlines. As Secretary Lew notes in his letter to Congress, October 17th is the date when “extraordinary measures will be exhausted” and the Treasury will run out of borrowing capacity – this is not the date the Treasury will run out of cash. We expect that the $30 billion in cash they have will last until November 1st, when several large program expenditures are scheduled. While on one hand this gives politicians more time to strike a deal, on the other it also means they have more time for political gamesmanship (ping pong, anyone?). Nonetheless, we believe there is a zero percent chance of a federal government default at that time. The US government will pay its bills.

Reinhart's note is set up as a Q&A, and in the last question he expands on how events could unfold as the government runs out of cash.

Does a last resort option exist to save the US from default?

Bottom Line: Yes, but it will break one of three laws.

If the Treasury is unwilling to stretch the definition of extraordinary measures, on the day that the Federal Reserve predicts that the Treasury will run out of cash in its account and the Treasury is bound by the debt ceiling, it should pend all payments and await instructions from the Treasury. As a result, all principals will face the prospect of violating one of three laws:

The Second Liberty Bond Act of 1917 that establishes the debt ceiling;

The Federal Reserve Act that prohibits the Fed from lending directly to the Treasury; or,

The 14th Amendment of the Constitution that holds that the debt of the US government, lawfully issued, will not be questioned.

They have to break a law. Full stop. We think at the end of the day officials will avoid violating the Constitution by indicating that they have been given inconsistent instructions and are obeying the one with the most important precedent.

If it is the Secretary of Treasury that decides to contest 1, then the Treasury will issue debt and raise cash.

However, the debt arguably does not have the protection of Amendment 14, as it was not necessarily lawfully issued, so it may not be default free. That is, in the European context, the Treasury will issue “red” bonds in order to pay the maturing principal and interest on “blue” bonds. The reds turn blue when the debt ceiling is increased.

If it is the Chairman of the Federal Reserve that decides to contest 2, then the Treasury General Account (TGA) goes into overdraft and all Treasury operations continue.

Either a Secretary of Treasury who holds 3 as the overriding instruction or a Chairperson of the Federal Reserve who waves 2 saves the global financial system and at most risks being impeached or fired. That seems like a reasonable risk and reward trade-off. The government of the United States is not going to default.